She added that fellow agency Moody's, who rates Italy three notches higher than S&P does, was now widely expected to follow suit with its own downgrade.

'Future uncertainty'

Italy recently passed an unpopular austerity budget, but S&P suggested this did not go far enough.

"We believe the reduced pace of Italy's economic activity to date will make the government's revised fiscal targets difficult to achieve," S&P said in a statement.

"Furthermore, what we view as the Italian government's tentative policy response to recent market pressures suggests continuing future political uncertainty about the means of addressing Italy's economic challenges."

S&P criticised the austerity budget's heavy reliance on tax rises - including a one-percentage-point increase in VAT - saying that taxes are already high in Italy, and the increases would weigh further on growth.

The 60bn euros (£52bn, $82bn) of austerity measures laid out in the budget are equivalent to 2.8% of Italian economic output.

Rome aims to balance its budget by 2013.

But the government is now expected to cut its growth forecast for this year from 1.1% to 0.7%, and this may force it to revise its borrowing forecast up.

Analysis

By David WilleyBBC News, Rome

People I have been talking to are unanimous - the country desperately needs some strong measures. And in the opinion of Standard & Poor's, it isn't getting them.

It is going to be a rather bleak autumn and winter: cuts in social services, cuts in transport and rising prices, including a one percentage point rise in VAT last week.

There is an atmosphere of widespread dismay that the government's so-called austerity programme doesn't seem likely to bite.

Nor does it deal with two factors which colour the Italian economic situation: namely, the government's inability to deal decisively with widespread tax evasion at all levels, and the general lack of stimulus that it gives to the economy.

This is a country that has been stagnating under the leadership of Prime Minister Berlusconi for years now and doesn't show any signs of improvement.

The Italian finance minister, Giulio Tremonti, is meeting bankers and businessmen to discuss ways of boosting the country's growth rate.

Questions about the government's leadership played a major role in S&P's analysis:

"Even under pressure, Italian political institutions, incumbent monopolies, public sector workers, and... unions impede the government's ability to respond decisively to challenging economic conditions," the agency said in its report.

"It is unclear what can be done to break the deadlock between these political institutions and the government."

Contagion fears

Italy follows fellow eurozone countries Spain, the Republic of Ireland, Greece, Portugal and Cyprus in having its credit rating downgraded this year.

The surprise move by the ratings agency will fuel fears of contagion in the eurozone.

Italy has Europe's second-largest debt level and the cost of that debt has been rising in recent weeks as lenders to Italy have become nervous about its ability to repay loans.

Spain is also struggling to boost its flagging growth rate, and to bring its unemployment rate down from 21%.

"We are recovering more slowly than we would like," said the Spanish Finance Minister, Elena Salgado, on Tuesday.

She said her government would not lower its economic growth targets, although she conceded that if they were setting new forecasts today they might be different.

Nonetheless, the costs of borrowing for Italy and Spain were virtually unchanged on Tuesday morning following S&P's announcement.

Italy's bond yield, which indicates its cost of borrowing, hovering around 5.6% in early trading.

The euro rose marginally against the dollar to $1.37.

The latest news comes after concern over Greece and whether or not it will default on its loans hit markets hard on Monday.

The Greek government is in talks with the International Monetary Fund and the European Union about getting more bailout money released.

A second conference call to finalises Greece's latest austerity measures is set to take place later on Tuesday.

Earlier this month, S&P cut the credit rating of the US from AAA to AA+ for the first time in its history.